Amidst the catastrophic wildfires sweeping through California, widespread concern over potential financial fallout is understandable. However, Wells Fargo suggests that these disasters are unlikely to significantly impact the municipal bond market. Municipal bonds are a popular choice among affluent investors because the interest they generate is exempt from federal taxes, and potentially from state and local taxes, if the investor lives in the same state as the bond issuer. This tax advantage is particularly attractive to investors in high-tax states like California.
Recently, over 150 wildfires have ravaged southern California, consuming around 41,000 acres and obliterating at least 12,300 structures, tragically resulting in at least 24 deaths. Yet, historically, municipal bond issuers have managed to weather natural disasters quite well, without leaving investors in the lurch, according to an analysis from Wells Fargo led by Lucas Baker. “From a bondholder’s perspective, municipal issuers have consistently demonstrated resilience, historically recovering from natural disasters without impairing bondholders,” Baker noted.
Interestingly, data from Moody’s Ratings supports this assertion, showing that no state or local government with bonds rated by Moody’s has defaulted due to natural disasters. “Looking at the medium to long term, recovery efforts by FEMA and other agencies often stimulate economic activity and help stabilize financial operations and economic growth,” Baker explained. He cited Hurricane Katrina as a case in point—while it caused an estimated $105 billion in property damage back in 2005, affected communities still managed to meet their debt obligations fully and punctually.
For investors, munis are accessible either directly or through funds. While some of the largest municipal bond exchange-traded funds offer diversified holdings nationwide, others are focused on individual states, like California. Despite the fires, conversations are beginning to shift towards recovery. California Governor Gavin Newsom, recognizing this, issued an executive order on Sunday to relax certain reconstruction prerequisites, facilitating a swifter rebuilding process. Alongside, FEMA is actively engaged, covering between 75% and 100% of emergency costs and up to 75% of hazard-mitigation projects, crucial to stabilizing communities and ensuring that bondholders receive their due.
While there are concerns, Baker acknowledges that the market might feel some short-term impacts. “There could be potential cash-flow disruptions for issuers due to obstructed operations, increased demand for services, overtime costs, or short-term revenue decreases,” Baker mentioned. A temporary delay in bond payments could also emerge due to operational disruptions in finance, trust, or paying agent offices, he added.
Deciphering the full scope of the calamity and recovery timeline is premature, but Baker believes cities and counties with broad tax bases are likely better equipped to handle short and medium-term credit pressures. Similarly, large institutions such as healthcare or higher education centers without taxing power, yet with sizable reserves, should hold up well. However, munis with narrow, limited tax bases, such as tax-allocation bonds, might be more vulnerable to even modest decreases in their tax and customer pools, warns Baker. Furthermore, single-asset obligors might face immediate cash-flow issues, he stated.
Uninsured bonds in heavily impacted locations, especially those rated BBB or lower, could be at a heightened risk of dropping below investment grade or experiencing payment defaults, Baker pointed out. He advised, “Investors worried about headline or credit risk might want to reassess and potentially reduce their exposure during this period.”
